Economic Watch; Debate on Puerto Rico's Future Has a Bottom Line

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If President Bush and Gov. Rafael Hernandez Colon have their way, the Commonwealth of Puerto Rico will get the chance next year to vote on joining the Union or casting it off forever.

For many supporters of a binding referendum, the principle of free choice matters more than the choice that will be offered among the three alternatives: statehood, independence and retention of commonwealth status. And as enabling legislation inches its way through e Congress and the debate in Puerto Rico builds momentum, practical questions of jobs and government benefits, not national or cultural integrity, are looming largest.

''Only in Puerto Rico,'' said John Stewart, a consultant to the commonwealth's Economic Development Administration, ''do the taxi drivers refer to sections of the Federal tax code by their numbers.''

Effects Would Be Momentous

The economic consequences of a change in political status would be momentous for the island's 3.4 million inhabitants.

Statehood would make Puerto Ricans eligible for billions of dollars more a year in food stamps, medical insurance and income support payments, and this might explain why statehood narrowly leads the commonwealth option in early polls.

But even advocates of statehood or independence concede that under either option the loss of Federal tax benefits linked by law to commonwealth status would lead to an initial decline in employment and would force sharp cutbacks in the size and reach of local government. Computer simulations by the Congressional Budget Office suggest that growth would be slowed one to two percentage points a year into the foreseeable future.

The best hope in the long run, economists on all sides seem to agree, is that statehood or independence would shatter the sense of Puerto Rico as an economic appendage of the United States, stimulating the savings and enterprise that are needed to break the island free of its dependency.

Puerto Rico's commonwealth status carries with it a unique package of privilege and penalty. Its residents cannot vote in Presidential elections. Nor are they entitled to all the social benefits available to residents of the 50 states.

Current Benefits

But Puerto Ricans are American citizens, free to live where they choose. If they live in Puerto Rico, they pay no Federal income tax. And under a benefit that is crucial to the island's economy, subsidiaries of American businesses in Puerto Rico enjoy unrestricted access to American markets but pay no Federal taxes on profits.

That benefit (Section 936 of the United States Tax Code) and the commonwealth's own generous tax incentives for new businesses have induced hundreds of manufacturers to build plants in Puerto Rico. Most are makers of pharmaceuticals, chemicals and electronics equipment, industries that are well positioned to transfer to their island subsidiaries the profits they earn on the mainland from intangible assets like patents and trademarks. And as a result of this encouragement of highly automated industries, relatively few jobs have been created for each dollar of investment.

But so many tax-sheltered investment dollars have been attracted to the island that the overall effect on the size and shape of the Puerto Rican economy has been enormous. Output per person grew at a remarkable 5 percent a year in the 1950's and 60's. The rate of growth plunged to about 1 percent in the mid-1970's after the virtual collapse of the island's tax-sheltered oil refining industry, but it has picked up to 3.6 percent over the last five years.

The overall economic performance, supplemented by substantial infusions of Federal aid and borrowed capital for improvements, has been superb. The densely populated, resource-poor island now enjoys a living standard far above that of any Caribbean or Latin American nation.

The catch, says Bernard Wasow, an economist at New York University, is that the Puerto Rican economy has been cultivated as a fragile orchid, seemingly incapable of blossoming outside the Federal hothouse. Manufacturing, virtually all of it free from Federal corporate taxes, accounts for 40 percent of its output, while agricultural production accounts for only 1.5 percent, far below the level one might expect to find in the tropics.

Labor Costs Are High

And labor is in great oversupply on the island. But Mr. Stewart says the effects of Federal minimum wage laws, which have kept worker compensation high by island standards, and the unlimited right of workers to move to the mainland, where they are drawn by higher salaries and greater diversity in employment, have kept labor costs close to levels in the United States. Per capita output in Puerto Rico is two-thirds that of Singapore, Mr. Stewart notes, but worker compensation is twice as high. This discourages the growth of labor-intensive industries, like tourism and apparel, that might absorb excess workers.

Not surprisingly, elected officials in the commonwealth are under chronic pressure to provide the well-paying jobs that private employers cannot. One in four Puerto Rican workers is employed by the Government, and at a cost that Puerto Rico would be hard pressed to cover without Federal aid and tax revenue from the corporations on the island drawn there by the tax breaks.

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Either change in status contemplated in the referendum would upset this equilibrium. The Congressional Budget Office confirms that under statehood, Federal aid to individuals would increase to $5 billion by 1995 from $2 billion now, and would provide about one-third of the island's personal income.

The loss of preferred tax status for corporations could prove devastating to the productive economy. The Congressional Budget Office asserts that without the tax incentives, manufacturers would scale back investment in their plants by one-third to one-half. As a result, the rate of economic growth would slow, increasing unemployment by four to seven percentage points by the year 2000. KMPG Peat Marwick, a consulting firm working for partisans of the commonwealth option, predicts that 145,000 jobs, or one in six, would be lost.

Many supporters of the statehood option concede that there would be disruptions in manufacturing, but they believe that the losses would be made up quickly by businesses attracted by the opportunity of expanding into the 51st state.

But if they are wrong, Puerto Rico's economic problems would multiply.

Cutbacks in the Offing

Any reduction in Section 936 profits or wage income would cut into Puerto Rico's tax revenue and its ability to borrow capital for development. Under statehood, it could not easily make up the loss by raising the personal income tax. Indeed, there would be pressure to reduce tax rates because middle- and upper-income families would be required to pay Federal taxes for the first time.

Consequently, says Jose Villamil, a private economic consultant in San Juan, the government would be forced to cut back. That need not be a bad thing, even in the eyes of statehood proponents. Michael McKee, a Washington-based consultant to the party that supports statehood, sees benefits in a sell-off of money-losing enterprises owned by the commonwealth. But there is little doubt that jobs would be lost.

Forming an independent nation would also mean the phasing out of Federal aid. And without Federal money, Mr. Wasow, the New York University economist, said, ''Puerto Rico could become the inner city of the Caribbean.'' Moreover, the new nation could have serious problems in replacing the capital now being borrowed from Wall Street or in attracting companies like those lured there by tax incentives.

The Congressional Budget Office estimates that the cost of borrowed capital would rise by at least two percentage points, because interest on the bonds of an independent Puerto Rico would be fully taxable to American investors.

Puerto Rico would become eligible for help from the International Monetary Fund and the World Bank. But the line for assistance is already long, and with the breakup of the Soviet empire, it is likely to get much longer.

Independence's Edge

But an independent Puerto Rico would have a significant edge over a Puerto Rican state in attracting corporate investment. United States law gives American companies a $1 tax credit for every dollar they pay in foreign taxes. So if Puerto Rico were to set its tax equal to the Federal rate and then plow much of the revenue into subsidies that made the island a more attractive place to operate, it might win a corporate following.

But Mr. Stewart, the commonwealth's consultant on development, is skeptical. If that strategy is so promising, he asked, ''Why don't other third world countries try it?'' Most, he notes, can already offer foreign corporations the advantage of far lower labor costs.

The strongest economic cases for statehood and independence rest on the idea that the Puerto Rican economy must change radically to achieve its potential. Partisans of statehood make much of the intangible benefits of stability conferred by full partnership in the Union. A more mixed blessing might be the harsh lesson in modern capitalism, as Puerto Ricans discovered that local government could no longer afford to be the employer of last resort, and that tax breaks could no longer substitute for entrepreneurial spirit in creating good jobs.

What applies to statehood applies in spades to independence. ''Instead of being a rich Caribbean country,'' Mr. Wasow said, Puerto Ricans now think of the island ''as a poor part of the U.S.''

Were the island to go it alone, Puerto Ricans might be willing to make the sacrifices that have permitted nations like South Korea and Singapore to make the leap into self-sustained growth. Specifically, they might accept lower wages to increase employment and become competitive internationally. They might also curtail consumption to pay for the capital that now comes entirely from Wall Street and the Federal Government.

''Statehood or independence could have big payoffs 15 years down the road, but the risks are enormous'' Mr. Villamil said. ''Commonwealth is a safe bet.''

A version of this article appears in print on May 15, 1990, on Page A00018 of the National edition with the headline: Economic Watch; Debate on Puerto Rico's Future Has a Bottom Line. Order Reprints|Today's Paper|Subscribe